The Second Belaśnde Government

The return to democracy allowed Peruvians to choose among strongly
left, strongly conservative, or middle-of-the-road parties. They chose
Belaśnde and his party as the middle road, but it led nowhere. The Belaśnde
government tried to return the economy to a more open system by reducing
barriers to imports, implementing financial reforms intended to foster
private markets, and reversing the statist orientation of the Velasco
system. But the new approach never had a chance to get very far because
of a series of macroeconomic problems. On one side, the government was
rightly concerned about continuing inflation but made the mistake of
focusing the explanation on monetary growth arising from the export
surplus it inherited at the start. That position made it seem
undesirable to continue trying to promote exports and desirable to raise
domestic spending and imports. On the other side, President Belaśnde's
personal and political objectives included using public investment
actively to develop the interior of the country and to answer evident
needs for improved infrastructure. Seeing the export surplus as the key
macroeconomic source of imbalance, the government decided to eliminate
it by removing import restrictions, slowing nominal devaluation to allow
the real exchange rate to appreciate, and increasing government
investment spending.

The real exchange rate appreciated through 1981 and 1982, public
sector investment rose 54 percent in real terms from 1979 to 1982, and
public sector consumption rose 25 percent during the same three-year
period. The combination effectively turned the current-account surplus
into a large deficit, as increased spending plus import liberalization
practically doubled imports of goods and services between 1979 and 1981.
The appreciation also turned manufacturing exports back downward, and a
plunge in external prices of primary exports brought them down too. And
then the mistake of focusing on the earlier export surplus as the main
cause of inflation became clear: the increases in spending led to a leap
of inflation despite the return to an external deficit. The rate of
inflation went from 59 percent in 1980 to 111 percent by 1983.

Nothing improved when the government then tried to go into reverse
with contractionary macroeconomic policies and renewed depreciation.
Output plunged, but inflation once more went up instead of down, to 163
percent by 1985. By this time, pessimism about the government's capacity
to solve anything, inflationary expectations turning into understandable
convictions, and the price-increasing effect of devaluation all combined
to give Peru a seemingly unstoppable inflation despite the elimination
of anything that might be considered excess demand. The government
apparently lost its sense of direction, retreated from its attempt to
reopen the economy by returning to higher tariff levels, and otherwise
did little except wait for its own end in 1985.